Markets: Pension Pothole
New York: July 25, 2005
By John R. Stephenson

By 2030, some 77 million Americans will be hobbling into old age with twice as many retirees as there are today but only 18 percent more workers. Adding to a potential storm, is a chorus of fresh warnings suggesting that pension plans, both private and government, are seriously underfunded - putting the retirement plans for millions at risk. The challenge of meeting the future liabilities of retiring workers appears to be exacerbated today by a sagging stock market and a lackluster bond market. Just how will America handle this demographic overload?

Pension plans across the nation are in trouble and the situation is getting worse. With hoards of people getting set to retire and overly optimistic projections of future returns from plan assets, a potential crisis is in the making.

One gauge of the pension plan problem is the sorry state of the Pension Benefit Guarantee Corporation (PBGC) the quasi-government agency that insures America's private, defined benefit plans (plans which guarantee a specific level of retirement income for each worker) of some 44.3 million American workers. Just a month ago, Executive Director Bradley Belt was telling the Senate Finance Committee that, amongst the pension plans that the PBGC monitors, the reporting plans recorded a record shortfall of some $353.7 billion - up from $279 billion a year earlier. In the 2004 reports filed with the PBGC covering some 1,108 corporate pension plans, the aggregate average underfunding (projected future obligations to retirees less projected future dollars) was a staggering underfunding of 31%. But the problem is actually worse than reported. The reports to the PBGC are only required for company pension plans with more than $50 million in unfunded pension liabilities - meaning smaller pension problems were not included in the total. According to figures released by the Pension Benefit Guarantee Corporation, the actual dollar value of underfunding currently is closer to $450 billion.

But those figures are only for private corporations and don't include the mounting problems of public pension plans. A recent report on public pension plans by Wilshire Associates concludes that the average underfunded plan has a ratio of assets-to-liabilities of 78%. With city, county and state pension plans holding some $2.2 trillion in assets, this underfunding works out to a further $400 billion owing on public pension plans. Compounding the problem is the fact that not only are the assumptions about the potential future returns the pension plans hope to achieve way too optimistic, but every dollar that is underfunded is another dollar that the fund loses the potential gains (returns) from. In other words, if public pension plans are already recording a shortfall of roughly 22%, then they not only have to make up the shortfall (22%) but also the projected return that they need to make to fund the obligations to future retirees.

According to Business Week magazine, the problems could be much worse than originally thought. As they report: "As much as states are throwing into pensions, they may owe even more. Despite a 2004 stock market rise that should narrow some of the gap, pension experts at Barclays Global Investors say that if public plans calculated their obligations using the more conservative math that private funds do, they would not be $278 billion under, but more than $700 billion in the red. It's just ruining the financial picture for states and municipalities," says Mathew H. Scanlan, managing director of Barclays, one of the largest pension-fund investment managers. "You're looking at a taxpayer bailout of this pension crisis at some point."

While the problem is bad now, it is likely to get a whole lot worse. The reason? The whole idea behind a pension plan is to invest money today to fund the obligations of pensioners in the future. While the obligations (benefits to retirees) are known today, it is uncertain how much money will be available in the future. In order to calculate the under or over funding that is currently the situation, the pension plans calculate the difference between their future obligations and their current assets assuming a certain rate of return on those assets. The problem? The rates of return being assumed for these pension plan assets is way too high.

Most pension plans are assuming that they can get somewhere between 8 and 9 percent return on their assets each and every year. For a while, they were doing a little bit better. According to Whilshire Associates, last year the average plan recorded returns of 10.8 percent. But that was when the stock market was doing a whole lot better than it is today. With the rates of return on long-term bonds no more than 5 percent and the typical pension plan holding 40 percent bonds and 60 percent stocks, it works out that the equity portion would need to return at least 10 percent for the pension plan to show 8 percent overall returns. But since the stock market tends to grow at just GDP plus inflation over long periods of time, this assumption of 10 percent growth rate in equities might be very optimistic. Roughly speaking, if the Dow Jones Index (30 large blue chip stocks) were to compound at 10% a year we would be looking at a Dow Jones Index of 22,000 by 2015 - up from 10,615 today. This is highly unlikely.

But we've only started to scratch the surface of the problem. It is possibly far worse if one considers the affect of promised health care benefits to retirees. According to Business Week "There's more bad news. One major category of cost isn't disclosed at all: how much retiree health care has been promised to public retirees. No one can estimate how much these promises will add up to, but they're sure to be in the tens of billions, and only some states seem to have put aside reserves for them, according to bond analysts. That's chilling, given how quickly medical costs are rising. After a pitched battle, the Governmental Accounting Standards Board (GASB), the independent accounting standards-setter for state and local governments, has finally begun to require states to disclose these liabilities. Numerous unions and state government representatives objected to the change, says GASB member Cynthia B. Green, "not because (unions and states) didn't think these were important, but because they thought once the governments did their studies and found what the price tag was, they would be concerned or, if not concerned, staggered." The requirement will be phased in beginning in late 2006.

With corporate pension plans in tatters and public pension plans in worse shape, there is a likely tax crunch floating your way in the next ten years. Unlike private pension plans, (witness the recent debacle with United Airlines) which can be cut or simply abandoned, public pension plans will have to meet their commitments. According to the guys at Barclays, the shortfall in public pension plans in ten years could be as high as $2 trillion. The solution to the underfunding of public pension plans? Taxes will have to be raised or services will need to be cut to fund increased contributions.

With higher taxes likely, the stage is being set for future tax-payer revolts. The entrepreneurial class is most likely to vote with their feet and this is already happening in countries like France where oppressive tax regimes are causing entrepreneurs to pick up stakes. The same will happen here as the attraction of lower tax communities with fewer pension commitments is going to rise. Property values are likely to decline in cities with high pension obligations as young people pick up stakes and move to other states or countries where the tax regime is more favorable.

Investors worried about the rising risks to public pension plans should adopt a strong defense. Make sure that you are self-reliant and that you are looking after your own retirement needs by creating your own pension plan based on conservative return assumptions - a 5 percent rate of return on your assets. Achieving rates of return of 10 percent or more is going to be increasingly difficult as corporate pension plans falter and management has no choice but to expense the shortfall which will result in lower corporate earnings.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article